India’s CAD rises when output falls and not when demand rises.
India’s current account deficit (CAD) has been a source of worry and merits deeper discussion.
The CAD reached 4.2 per cent of gross domestic product (GDP) in 2011-12. As global risks rose, capital inflows were lower at 3.7 per cent, requiring the Reserve Bank of India’s (RBI) draw-down of reserves, amounting to $ 12.8 billion, to make up the difference.
EXCESS DEMAND OR SUPPLY SHOCKS?
Does such a large CAD imply that the country’s aggregate demand (consumption plus investment) hugely exceeded its aggregate domestic output or income?
The problem in this formulation is that 2011-12 also happened be a year when India’s GDP growth rate fell to 6.5 per cent, compared to 8.4 per cent in the previous year. Moreover, growth in aggregate demand categories like consumption and fixed investment fell from about eight to five per cent.
Research at the Indira Gandhi Institute of Development Research shows the Indian CAD is countercyclical. That is, it rises when output falls and not when demand rises. This is exactly what happened last year as well.
In this, India – or the South Asian region – is unusual. In all other emerging markets, the CAD tends to be pro-cyclical, linked to overconsumption in good times. Overconsumption, which can also be due to low policy credibility and the associated belief that good times may not last, leads to widening CADs in such times.
In developed countries, the CAD exhibits no such firm relationship with income fluctuations.
A countercyclical CAD in India’s case suggests dominance of external supply shocks rather than excess demand factors.
For example, if oil shocks raise costs, and as a result growth falls, the CAD would rise along with falling growth. It can also be due to export-led growth: As exports rise, they raise income and reduce the CAD. On the other hand, a sudden collapse of export markets, due to a global shock, reduces income and increases the CAD.
In line with this analysis, 2011-12, the year of the peak CAD of 4.2 per cent of GDP, saw both a sharp rise in oil prices and fall in growth. As against this, the CAD was only 1.3 per cent in 2007-08, a year of high consumption, investment and output growth.
In the first quarter of this fiscal, however, softening international oil prices have reduced the rupee value growth of oil imports, thereby implying the CAD may improve. The table shows the sharp fall in import growth in Q1 this year, compared to what it was in 2011-12.
THE ROLE OF PRICES
If a CAD is not due to excess demand, can it be due to prices that encourage excess imports?
A depreciation of the rupee increases the price of the country’s imports, and also makes its exports cheaper for foreigners. But this may be a blunt instrument in the Indian context, where oil and gold account for a major share of imports, while imported machinery and other intermediate goods are inputs, whose higher costs would raise production costs here.
The effect of depreciation on exports is normally delayed and uncertain. Exports actually grew at double digits in 2010-11, when the rupee appreciated on the whole. The table shows export growth has been negative this year, when the currency has depreciated sharply.
Diversification of the export basket and the destinations they go it, improvements in domestic supply conditions, and overall global demand conditions are more reliable export boosters than depreciation. Excess volatility in exchange rates, in fact, does not help exports. Since sharp depreciation today could be reversed tomorrow, exporters are wary.
As regards reduction in imports, it is possible to achieve that by just raising the relative prices of the major imported commodities. Part of the reason why demand is inelastic is only because prices do not, or are not allowed to, adjust. The recent higher gold taxes have proved helpful. Greater pass-through of oil prices can do the same, besides also serving the important goal of improving the energy efficiency of the economy.
Some nominal depreciation is required to correct for India’s higher inflation rates, softening global oil prices now make it possible to absorb it without adding to inflation. But overcorrection, leading to real depreciation beyond competitive rates, will only sustain inflation.
Specific relative prices and overall structural changes, which can improve the CAD, are in the domain of fiscal policies. What monetary policy can do is prevent excess movement of exchange rates.
Excess demand, we have seen, is not driving the CAD, since growth has fallen below potential and the latter itself is falling as investment slows. Even so, the RBI cannot afford cuts in its repo rates now. Credit growth has fallen, but deposit growth has fallen even more. If banks cannot, then, reduce deposit rates – post-tax real returns to them are still negative – it limits the transmission of lower policy rates.
Loan rates can come down only if spreads for banks reduce. Easier money market conditions can contribute to that. High food prices impact inflation expectations. It is, hence, necessary to anchor these – since the monsoon is poor. Policy rates are a good instrument for this, as interest rates give a clear signal.
Liquidity can, however, move in the opposite direction, to support stable credit targets and also the supply response that lowers inflation expectations. Easier liquidity is also required to compensate for the drying up of international credit sources.
(The author is Professor, Indira Gandhi Institute of Development Research.)